Dear Entrepreneur: Think Cash, Not Ideas

November 24, 2011

Last week NBA legend-turned-entrepreneur Magic Johnson sold his Starbucks franchises back to the corporation for a reported $75 million. Rumor has it, he’s freeing up some cash to invest in a professional sports team (he also sold his stake in the Los Angeles Lakers basketball team).

About 12 years ago, Magic Johnson formed a joint venture franchise program with Starbucks (Urban Coffee Opportunities) to open coffee shops in developing urban areas such as Harlem. The goal was to reinvigorate under served neighborhoods with jobs. It was a a successful partnership. Under the Urban Coffee Opportunities, more than 100 Starbucks operate in under served urban neighborhoods across the country, including Atlanta, Chicago, Detroit ,Los Angeles, New York and Washington, D.C.

Starbucks’ purchase of Magic’s 50 percent share of the joint venture is an important endorsement of the power behind small businesses with real cash flow models. It’s also a counter-intuitive lesson to leaders about how good businesses and good partnerships can work in under served areas. Doing things where others don’t — or won’t — inspires me and my colleagues in our daily work.

Our venture firm, Cue Ball, considers franchise opportunities. We’re selective, but we like the simplicity of their business models. The attractiveness of most retailing and restaurant franchise opportunities comes down to the unit economics: how much money is required to open a unit, and how long will it take to get the payback? If the concept is good, there should be a healthy on-going cash flow stream. Let’s say you build a Starbucks for X dollars. The profits pay back that money in Y years, and you calculate the on-going cash flow minus requirements for ongoing maintenance and improvement. This can quickly give you a “back of the envelope” sense of how much money you can make, and you can quickly assess a concept’s economic potential.

In the “sophisticated” business circles of MBAs, tech entrepreneurs, and private investors franchise restaurants, retail and other consumer service startups produce a negative, knee jerk reaction. The cocktail conversation dismissal of these investments usually starts with the assertion that the vast majority of restaurants fail, and that such concepts require a lot of capital and time. Plus, they’re not Big Ideas. They’re not cool.

It’s true that most restaurants fail. Then again, most technology start-ups fail, too. And yes, you need capital and time to get them going. Of course, biotech companies spend a decade and billions of dollars just to bring a single idea to market. Still, tech investors will argue, in the “capital efficient” VC world we live in today, you can start and test the viability of digital media and social networking enterprises with very little capital before committing larger follow-on investments. But do they know that most restaurant and retail concepts have long used a similar stage-gating pattern for investing? To see if a restaurant chain concept can work, you start with one, and if you have unit economic success in that first unit, you replicate or improve on that success with subsequent units. At that point, risks have been significantly mitigated and there is an argument to be made that the subsequent capital required has relatively low risk relative to the return potential. Indeed, once the first few Starbucks in under served neighborhoods demonstrated success, the opportunity to repeat a cash-generating concept was quite high. Compare that to, say, a social media startup where risks persist and are constant as tech is a much more volatile and changing business than coffee service.

So why are tech and pharma and other sexy ideas VC darlings while coffee shops aren’t?

It is easy to get lost in the excitement of starting or investing in innovative start-ups and focus on big ideas and big markets, all the while forgetting that the most important business criterion besides the team is a cash flow model that works. The real focus in any investment should be on risk-adjusted returns and not on what investors consider cool. From an investing perspective, people and business models should always trump the idea and market. The “little guys” who have the simple idea but real cash flow models may have as much of a chance to create value as the “big thinking guys” who have the big idea without the cash flow model.

Magic Johnson knew this. In 10 seasons with the Lakers, estimates put his earnings (not including endorsements) at about $18M. Let’s round that up to $20M, or even $25M.

Over roughly the same number of years after his NBA career, Johnson’s Starbucks venture earned him more than three times that amount. Not bad for the kind of investment many VCs would dismiss before even finishing their cocktail.